Red Flags: IRS Taking a Tougher Look at Tax Deductions

MOST POPULAR

The Internal Revenue Service added a couple of notches to its enforcement belt in the past week. First came the disclosure that international financial services giant Credit Suisse is under federal investigation for helping U.S. citizens avoid taxes using foreign accounts. Then came multi-platinum rapper Ja Rule’s conviction for failing to pay taxes on $3 million he earned from 2004 to 2006. He was sentenced to 28 months in prison.

Gulp.

These major league tax fraud cases obviously are far removed from the experience of average taxpayers. But these high-profile examples of stepped up IRS enforcement can’t help but fuel worry, even among the most honest taxpayers: Will the IRS raise a question on your return? Was there a faulty calculation? Did you claim a deduction that will rise a red flag?

Here’s some unsettling news. Depending on your occupation, income and the kinds of claims you’ve made, there may be reason for concern. With government revenue in short supply, the IRS has begun bearing down on specific groups of wealthier taxpayers, and is showing far less understanding or sympathy than in years pastmany accountants say.

“Our firm has 21 offices up and down the West Coast, and in every office there’s been an increase in examinations,” says Gary Stirbis, who handles the IRS controversy practice at Moss Adams, the nation’s 11th largest accounting firm. “The IRS has been less flexible, and agents seem to be under internal pressure to collect more aggressively. This often creates quite a burden for individuals.”

After a sharp decline in enforcement activity in 1998, due to a directive from Congress to shift IRS resources to taxpayer service, enforcement levels still aren’t where they were, but they have gained significantly. Before Congress stepped it, there were 25,215 key enforcement staff positions at the IRS, but that number dwindled to below 20,000 in 2003 and 2004. But now they are up to 22,710 – not a big increase, but enough to turn up the heat a little more.

And new programs have been launched to help spot problem returns, according to Steven Miller, deputy IRS commissioner for services and enforcement. For example, last year, the IRS created the Global High Wealth Industry Unit, in which agents with various specialties will work in teams to evaluate wealthy taxpayers’ profiles. “When you look at the 1040, it doesn’t tell the whole story,” Miller says.

And this year, in an effort to crack down on under reporting of income, agents will begin reviewing credit card statements and cross-checking data against tax returns, Miller says. Big spenders who claim little income, beware.

While big returns on enforcement efforts come from wealthy taxpayers running afoul of the rules, don’t think you’re under the radar just because your income is a tiny fraction of Ja Rule’s millions.

The IRS likes small, inexpensive audits, because they can influence large numbers of taxpayers to be compliant, says Bill Smith, managing director of CBIZ MHM in Bethesda, Md. People who see a coworker or friend get audited are likely to be more careful in filing an accurate and honest return, he says. “One audit may only bring in $500, but if you can increase compliance in that group of taxpayers by 20 percent because people hear about the audits, then for the IRS its worth it,” Smith says.

For the general population, while the audit rate has been climbing steadily, the chance of coming under IRS scrutiny is still slim. The audit rate last year was 1.11 percent of all taxpayers, up from 1 percent the previous year.

But among some groups the audit rate is significantly higher. Those who operate their own businesses and are required to file Schedule C Forms (estimated by the IRS to be underreporting income by some $68 billion a year) have an audit rate of just over 4 percent. The wealthy get far more attention. The audit rate was 3.1 percent for taxpayers with income of more than $200,000 last year, and 8.1 percent for those earning more than $1 million.

Other broad areas of interest by IRS enforcement agents align with the biggest areas of suspected fraud, such as returns claiming refundable tax credits, over reporting deductions, and offshore accounts. Within these broad areas, the IRS often homes in on specific types of taxpayers or circumstances.

Call them pet projects or pet peeves, these are some of the IRS’s latest areas of focus, according to the agency and tax lawyers:

Interest deductions for home loansTaxpayers who are claiming big interest deductions on mortgages and equity loans have come under scrutiny, “because a lot of people have been borrowing on their homes for college tuition or just to live,” says Ira Rubenstein, a principal in charge of the New York region for MBAF-ERE CPAs, one of the nation's Top 40 certified public accounting firms.

Homeowners are allowed to claim an interest deduction for up to $1 million of mortgage debt, and up to $100,000 of home equity debt. “We worked with one auditor who looked at the amount of the deduction and said ‘That’s too high for the interest rate,’” says Phil London, a CPA and tax partner at Wiss & Company.

Adoption creditAfter the adoption tax credit was raised to a maximum of $13,170 last year and it became refundable – meaning you can claim it and get a refund even if you owed no taxes -- “the IRS is flagging anyone who took the adoption tax credit last year and asking for proof,” says Diane Michelsen, an adoption lawyer in Lafayette, Calif.

Kelly Robinson, of Kansas City, Mo., says she filed for the credit on her 2009 and 2010 tax returns after adopting a baby girl in 2009. Last spring, the IRS opened an audit of her 2010 return only, looking for receipts, canceled checks, the adoption decree and other documents from reams of paperwork supporting her credit. “It’s been very cumbersome, I’ve put together 45 pages of receipts so far,” she says.

Gifts of propertyThe IRS has been scouring state property transfer records and comparing them with tax records to find taxpayers who haven’t disclosed real estate gifts, says Beth Shapiro Kaufman, a partner at Kaplin & Drysdale in Washington, D.C. With property values depressed, gifting real estate has become more popular, particularly among wealthy folks.

Under current law, you must file a gift tax return for gift values in excess of $13,000. Anyone whose undisclosed gift exceeds the $1 million unified credit (the maximum you can give away in a lifetime without paying the gift tax) will be subject to hefty penalties and interest, Kaufman says.

Large donations relative to incomeThe IRS is sizing up charitable deductions against income, looking for discrepancies. “Some innocent retired people with low income have the wherewithal to make contributions, and get targeted,” says Greg Margarit, a tax partner at Boulay, Heutmaker, Zibell & Co.

Ultra richThe audit rate for taxpayers with more than $10 million in income rose from 10 percent to 18 percentlast year. And with the IRS’s new global wealth squad, these folks should expect a colonoscopy-style check-up rather than the old-style knee-knock exam.

Looking ahead, there are questions about how long the IRS can keep flexing its muscles at its current level. The agency has requested that its $12.1 billion budget be ramped up to $13.3 next year, but cuts appear likely. This may force the IRS to trim enforcement – or, it could mean taxpayer service will be scaled back first, making audits potentially more painful.

<p> <strong>Karen Hube</strong> is a freelance writer covering taxes, investing and personal finance. In addition to her work for <em>The Fiscal Times</em>, she writes a tax column for <em>The Washington Post </em>and contributes to Barron’s. She began her career as a beat reporter at The Pottsville Republican in Pennsylvania, moved to personal finance reporting at <em>Money</em> magazine, and became a staff writer at <em>The Wall Street Journal</em>. Since 2000, she’s written for a variety of newspapers, magazines and websites.</p>